International Financial Management

M.B.S – Final
Measuring exposure to exchange rate fluctuations
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1) Is exchange rate risk relevant?
Ans: The relevance of exchange rate is relied on some theories which are
provided below –

Purchasing Power Parity Argument: Exchange Rate Risk is irrelevant because

a. According to purchasing power parity (PPP) theory, exchange rate movements
are just a response to differentials in price changes between countries.
b. Therefore, the exchange rate effect is offset by the change in prices.

Investor Hedge Argument: According to this argument – it is not. Because

a. Investors in MNCs can hedge exchange rate risk on their own
b. Argument assumes that investors have information on corporate exposure to
exchange rate fluctuations.
c. Investor prefers company hedge.

Currency Diversification Argument: If a U.S.-based MNC is well diversified across

numerous countries, its value will not be affected by exchange rate movements
because of offsetting effects.

Stakeholder Diversification Argument: Some critics also argue that if

stakeholders (such as creditors or stockholders) are well diversified, they will be
somewhat insulated against losses experienced by an MNC due to exchange rate
risk.

2) Explain how transaction exposure can be measured?

Ans: The degree to which the value of future cash transactions can be affected
by exchange rate fluctuations is referred to as transaction exposure.

Transaction exposure can be measured in following ways –

1) By estimating “Net” Cash Flows in Each Currency.
2) By measuring the Potential Impact of the Currency Exposure.
a. Measurement of Currency Variability.
b. Currency Variability over Time.
c. Measurement of Currency Correlations.
d. Applying Currency Correlations to net Cash Flows.
e. Currency Correlations over Time.
3) By assessing Transaction Exposure based on Value-at-Risk -
a. Factors That Affect the Maximum One-day Loss
b. Applying VAR to Longer Time Horizons

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 c. Applying VAR to Transaction Exposure of a Portfolio
d. Limitations of VAR

3) Describe techniques to eliminate transaction exposure.

Ans: Transaction exposure exists when the future cash transactions of a firm are
affected by exchange rate fluctuations.

Generally MNCs use Hedging Techniques to eliminate transaction exposure is

detailed below –

Hedging includes:

Futures hedge,
Forward hedge,
Money market hedge, and
Currency option hedge.

◊MNCs will normally compare the cash flows that could be expected from each
hedging technique before determining which technique to apply.

◊A futures hedge involves the use of currency futures.

◊A forward hedge differs from a futures hedge in that forward contracts are
used instead of futures contract to lock in the future exchange rate at which the
firm will buy or sell a currency.
Recall that forward contracts are common for large transactions, while the
standardized futures contracts involve smaller amounts.

◊ a money market hedge involves taking one or more money market position to
cover a transaction exposure.
Often, two positions are required.
¤ Payables: ŒBorrow in the home currency, and invest in the
foreign currency.
¤ Receivables: Œborrow in the foreign currency, and invest in the
home currency.

◊ A currency option hedge involves the use of currency call or put options to
hedge transaction exposure. However, the firm must assess whether the
premium paid is worthwhile.

In general, hedging policies vary with the MNC management’s degree of risk
aversion and exchange rate forecasts. The hedging policy of an MNC may be to

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hedge most of its exposure, none of its exposure, or to selectively hedge its
exposure.

MNCs that are certain of having cash flows denominated in foreign currencies for
several years may attempt to use long-term hedging.
Three commonly used techniques for long-term hedging are:
¤ long-term forward contracts,
¤ currency swaps, and
¤ Parallel loans.

Sometimes, a perfect hedge is not available (or is too expensive) to eliminate

transaction exposure. To reduce exposure under such a condition, the firm can
consider:
¤ leading and lagging,
¤ cross-hedging, or
¤ currency diversification.

[Basic…Not to be provided in exam]

The act of leading and lagging refers to an adjustment in the timing of payment
request or disbursement to reflect expectations about future currency
movements.

Expediting a payment is referred to as leading, while deferring a payment is

termed lagging.

When a currency cannot be hedged, a currency that is highly correlated with the
currency of concern may be hedged instead.

The stronger the positive correlation between the two currencies, the more
effective this cross-hedging strategy will be.

With currency diversification, the firm diversifies its business among numerous
countries whose currencies are not highly positively correlated.